Here’s Why We Need the Small Business “Zombies”

Back in the Go-Go ‘90s when venture capitalists were flush with cash, they would cast a wide net looking for investments. The idea was to seed 10 or more small or start-up businesses, confident that one or two of them would be home runs.

If a venture capital firm played its cards right, two firms would develop into stellar performers, four companies might fail and four others would be so-so performers, that is, solid profitable businesses, but with slower growth tracks or less upside potential.

In the industry, the so-so firms were derisively called “zombies” because they were considered half-living, half-dead. Sure they were solid small- to medium-size firms, but they would never produce the 10-times to 20-times returns that pleased investors and justified fat fees.

As a result, the companies lingered in the portfolio until they could be sold or dismembered. But an invasion of zombie companies would certainly be welcome right about now. With the economy barely producing jobs, and unemployment doggedly above 9 percent, venture capitalists could play a key role spawning solid, if not spectacular, small- and medium-size zombies to really help rebuild the economy.

But that isn’t happening. The industry, or what’s left of it, is still trying to swing for the fences. It’s shifted focus away from start-ups and it’s targeting funds at late-stage companies that already look like winners, hoping to cash out quickly.

Bill Brandt, co-founder and managing partner of Channeltivity, an online company that helps firms manage channel marketing and sales strategies, believes a paradigm shift is needed in the venture capital industry.

In addition to Channeltivity, Brandt is an entrepreneur, business consultant and a managing partner at SWOT Management Group, a global consulting firm that provides technology sales and channel development solutions to small and mid-size firms. He is also a board member of the Entrepreneurs Organization (EO), a professional development group made up of more than 7,500 high-level business executives from around the globe.

“I think what happened is during the ‘90s, venture capital became very popular,” he said in a recent interview. “The stock market was doing well so a lot of people put money into those portfolios. Basically the amount of capital under management in the ‘90s up through the dot.com bust grew exponentially. And after the dot-com bust, it continued for 10 more years.

“What you ended up with was a large population of VCs, who probably were not very well qualified, and they built mechanisms for drawing in deals and built a mentality that returns would be endless.” But as an asset class over 20 years, venture capital investments as a whole actually failed to make a return, he explains.

Indeed, the industry has suffered immensely in the stock market crash that followed the collapse of the financial system. Today, venture capitalists in the United States widely expect their industry to continue contracting at least through 2015, according to the most recent survey by the National Venture Capital Association.

In fact, more than 90 percent of U.S. survey respondents believe that as venture capital contracts in the United States, countries like China, India and Brazil will see their industries grow and begin to rival ours.

“Traditionally strong markets like the U.S. and Europe will continue to be important hubs despite consolidation in the number of venture firms,” said Mark Jensen, partner, Deloitte & Touche LLP and national managing partner for venture capital services. “However, the stage has now been set for emerging markets like China, India and Brazil to rise as drivers of innovation as they are increasingly becoming more competitive with the traditional markets.”

“You have this 40 percent of venture backed companies that could become good companies, but because of the dynamic of the VC needing the exit, it just becomes an untenable situation. There is no exit mechanism for those guys. I’m stuck with the VC, they’re stuck with the entrepreneur, We hate each other, so what the hell do we do with that?”

The answer Brandt says is that venture capitalists need to stop swinging for the fences and build a model that can live with singles, doubles and triples. But can the industry make a living off of zombie companies?

“Those are great companies,” he interjects. I’d love to have a bunch of $10 million companies turning a profit with happy employees. I’d love that. But that’s not the venture model”

The model he looks to is a group called the Angels Den in Great Britain. It was founded by Bill Morrow, who began his career as an accountant for Richard Branson’s highly entrepreneurial Virgin companies and later went into investment banking. Today, he calls himself a serial entrepreneur.

His group is Europe’s largest “equity funding facilitator,” according to its website. It brings entrepreneurs together with angel investors, who write might checks for anywhere from $250,000 to $8 million to help seed new companies.

“The reason they are investing is because they like the entrepreneur, they think they’ve got a neat idea and they think their dollar can help. They are not looking for a 10-x return. They’re not going to make a bunch of investments; they’re going to make one or two and help that company grow.”

“Their definition of success is to build a good enduring business and make it climb as fast as it can climb in a sustainable way that creates value.”

Brandt believes the next wave of capital development will ultimately come from individual high-net-worth investors, like those represented by Angel’s Den, who have “been there and done that.”

“I think what we’re going to need, if you really want to fuel that job creation engine, it’s a lot of these companies that really have average revenues of $18 million. That’s not interesting to a VC today,” he says.